A long time ago in a galaxy
far away, or it least it seems that way, I hammered-out an essay on derivatives
powerhouse US superbank JPMorganChase.
In my original essay, delicately titled “The
JPM Derivatives Monster”, I outlined some incredible research my research
group had performed investigating the gargantuan derivatives dominance of elite
Dow 30 money-center bank JPMorganChase (JPM-NYSE).

The essay was, fortunately or
unfortunately depending on one’s perspective, published the Friday before the
horrific September 11 attacks. Needless to say, the arcane and often confusing
world of derivatives was all of a sudden infinitely less important than coping
with the grisly and heart-wrenching aftermath of the notorious terrorist attacks
on America.

Even rightfully relegated far
beneath the long dark shadow of the tragedy, and even though the essay tipped
the scales at almost 7500 words, it drew over a hundred-thousand hits and
hundreds of comments from all over the planet. I was personally very surprised
by the popularity of the original complex JPM Derivatives Monster essay because
derivatives themselves are so difficult to understand and I assumed that
derivatives were pretty low in significance on most investors’ radars and
worldviews. Regardless, the huge response to the essay from almost two-dozen
countries as far away as Germany, Switzerland, Russia, China, and Singapore has
been overwhelming.

The original essay showcased
data that JPM is required by law to report to both the United States
Office of the Comptroller of the Currency
and the United States Securities and Exchange
Commission. In early September, the most current data available on the
derivatives positions of US banks was still from the first quarter of 2001.
Today, Q3 2001 official OCC derivatives data is available and not too far into
the future the Q4 2001 derivatives report will be posted by the OCC.

This essay is simply an update
of the original “The JPM Derivatives Monster” essay. If you have read and
understood that earlier work you will gain far more out of this essay. I try to
write the vast majority of my weekly Internet essays as stand-alone and
self-contained essays, but this one is atypical. I am assuming that you command
the basic background and knowledge of derivatives articulated in the earlier JPM
Derivatives Monster essay (henceforth called “Monster”). Certainly, if you have
questions on definitions, concepts, research, data origins, the data deployed
here, etc, the first place to go look is the September essay.

Before we begin this round, an
important disclaimer is in order. When I penned the earlier Monster essay, my
partners and I had absolutely zero exposure to or stakes in JPM, either long or
short. After we completed the work and research behind the original Monster
essay however, we were so astonished that my partners and I both bet against JPM
with our own capital and recommended JPM short positions and JPM put options to
our private consulting
clients and our Zeal
Intelligence private newsletter subscribers.

We strongly believe that it is
dishonorable to discuss a company without fully disclosing long or short
exposure up front so everyone understands from where we are coming. Some folks
will be uncomfortable with our JPM short positions, which is great and not a
problem, and I strongly encourage you to read no further if this disclosure
sends up red flags in your mind. Still other folks are more comfortable knowing
that “our money is where our mouths are”, so to speak. It is crucial that we
all begin on the same page. On to the battle!

Our first graph is a direct
update from Monster. Derivatives data used here is from the official Q3 2001
“OCC Bank Derivatives Report”, “Table 1”. Since the numbers shown below are so
mind-blowing that they utterly defy belief, I strongly encourage you to go
download the original PDF file and see the huge derivatives pyramid with your
own eyes at
http://www.occ.treas.gov/deriv/deriv.htm (specifically the file is at
http://www.occ.treas.gov/ftp/deriv/dq301.pdf). Please don’t just take our
word for it! ALWAYS do your own due diligence!

Amazingly, the total
derivatives positions held in terms of notional amounts by US banks literally
exploded in the six months between the Q1 and Q3 reports. The US banks ramped
up their derivatives positions by an absolute 16.8% in a mere six months, or
$7,362b (yes, that is seven thousand BILLION, or over seven TRILLION dollars).
For comparison the US GDP was only up an anemic 0.8% over the same six months.
The exploding broad US M3 money supply that Greenspan is frantically pumping
like there is no tomorrow in his daring
Greenspan Gambit is
“only” up 5.1% over the same period. Any way you slice it, the piling-on of
over $7t of additional derivatives exposure in six months is quite
extraordinary.

JPM’s share of the US banks’
titanic derivatives pie crumbled slightly over six months from 59.8% in Q1 to
59.3% in Q3. Lest the 2,781 large institutional investors that are holding
62.5% of JPM’s outstanding shares on behalf of their clients think that JPM’s
hyper-risky derivatives positions are abating however, in absolute terms JPM’s
derivatives exposure rocketed by $4,158b, or 15.8% to $30,434b in six short
months. To put a massive $4t+ increase in notional derivatives amounts into
perspective, the total broad US M3 money supply only crossed $4t for the first
time in United States history in July of 1989! $4t is BIG bucks folks!

Now JPM is a big bank, indeed
the flagship US money-center bank, but the derivatives pyramid the Dow 30
behemoth has created is even gargantuan by its giant standards. Per JPM’s
Q3 earnings
release, it commanded $799b in assets and $43b in stockholders’ equity on
September 30, 2001. (Per the official Q3 OCC report, the portions of JPM that
deal in derivatives only had assets of $663b, but we will grant JPM the benefit
of the doubt and use the larger asset number that it reported to the public.)

In terms of total assets, JPM
has implied derivatives leverage of 38 times ($30,434b notional derivatives
divided by $799b in assets), a big number. In other words, each $1 of assets
controlled by the uber-bank supports outstanding derivatives contracts with
notional values of $38.

For a commercial bank like JPM
however, asset size can be a misleading measure. Most of any bank’s assets,
including JPM’s, are offset by matching liabilities of the same magnitude. For
instance, when you deposit money in a bank those funds are really yours even
though you are letting the bank temporarily use them. A $100k deposit that you
make to a bank account becomes an asset for the bank that can be lent out but it
is offset by an equal $100k liability to you. Depending on what kind of
contract you have signed with your bank, Demand Checking versus Certificates of
Deposit for instance, you can often demand your money from the bank at any time.

Of JPM’s $756b in liabilities
at the end of Q3, only $47b were classified as long-term debt which means they
are due further-out than one year into the future. That leaves roughly $709b of
short-term liabilities, amounts that are due in the next 12 months. Of course
the vast majority of these liabilities will be rolled-over or replaced by newer
liabilities, but the huge amounts of current debt still give a general idea of
the short-term and potentially ethereal nature of JPM’s assets.

What really matters is JPM’s
stockholders’ equity, which contains all the capital that JPM stockholders own
free and clear, both funds that they have contributed and total profits earned
and retained in the entire long and distinguished corporate histories of JP
Morgan and Chase Manhattan. After the liabilities are subtracted from the
assets, JPM shareholders only own roughly $43b (exactly $42.735b) in equity.

Ominously, this relatively
small equity capital balance is supporting a crushing inverted derivatives
pyramid weighing a colossal $30,434b! $30,434b of notional value derivatives
controlled by JPM divided by its shareholders’ equity of $42.735b (note this is
a decimal-point in the equity number, NOT a comma as in the derivatives number)
yields a simply unfathomable implied leverage of derivatives to equity of 712
times! “Holy cow!” as they say in the American Midwest.

Every single dollar of
hard-won JPM equity ever contributed or retained is supporting a breathtaking
$712 in derivatives side-bets! 712x implied leverage!! Old John Pierpont
Morgan (1837-1913) is probably rolling-over in his grave, as he was a far more
conservative financier, industrialist, and deal-maker, not a pure financial
speculator or hedge fund manager!

This implied derivatives
leverage on equity has increased dramatically in the six short months since the
Monster essay, when it was “only” 626 to 1. The vast JPM inverted derivatives
pyramid continues to balloon ever larger, even through the absolutely unforeseen
extreme market turbulence of September 2001!

The inverted pyramid mental
picture is a great way to visualize this breathtaking leverage. Imagine Egypt’s
Great Pyramid of Giza miraculously inverted and stood-up balanced on its apex.
The relatively small point of stone pressing into the ground would have to
support millions of tons of stones above it (an estimated five or six million
tons), an exceedingly difficult task. Even if the apex of such an inverted
pyramid was constructed from some unbelievably strong cutting-edge space-age
composite that could support the crushing weight, an inverted balanced pyramid
is still very precarious and dangerous.

For example, what happens if a
mighty sandstorm roars out of the desert? The wind-loading forces coupled with
pelting sand exerting lateral pressure on one or two sides of the inverted Great
Pyramid would be enormous, the whole pyramid would act like a great sail. It
would be virtually impossible to keep the pyramid delicately balanced on its
apex unless the sandstorm was anticipated well in advance and appropriate
reinforcement countermeasures were deployed before it hit. This is probably why
you have never seen a medium or large building engineered to look like an
INVERTED pyramid, the top-heavy design is simply far too unstable. Relatively
small outside forces acting upon it are magnified tremendously by the leverage
between the broad high top of the inverted pyramid and its narrow pointy base.

In the derivatives world, a calm sunny beautiful Egyptian day for the inverted
derivatives pyramid is the equivalent of normal, sedate, fairly predictable
market conditions. The sudden sandstorms that cause massive wind-loading on
only one or two sides of the inverted derivatives pyramid are unforeseen market
volatility. As any options traders will tell you, and options are the simplest
form of derivatives, unforeseen volatility can lead to legendary profits or
bankruptcy-magnitude losses, all in a matter of mere trading days or hours. In
our chaotic and increasingly-weird post September 11th world, it is hard not to
imagine more unforeseen volatility sandstorms barreling off the desert dunes to
slam unexpectedly into one side of the greatest financial balancing act in world
history.

For those dabbling in
derivatives, making linear assumptions in a non-linear world can be lethal!

While JPM and two of its
money-center superbank peers, Bank of America and Citibank, now together control
a staggering 89.6% of the total US banks’ derivatives markets, 359 commercial
banks reported dabbling in derivatives to the OCC in Q3 2001. In a provocative
statistic, this number dropped dramatically by 9% from the 395 commercial banks
playing this same game six months ago in Q1. As more and more banks begin to
comprehend the enormous hazards of playing around in the unforgiving derivatives
markets, more and more are shedding their derivatives portfolios entirely to
greatly reduce the overall risk to their scarce and valuable capital. As fewer
banks risk their shareholders’ and depositors’ capital in this merciless
speculator’s game, the concentration of the market in only a few mega-banks’
hands will no doubt grow more extreme.

Also provocatively, it is
exceedingly interesting to note that derivatives exposures of this magnitude
have never before weathered the violent and unpredictable financial storms of
mighty secular bear markets. Derivatives essentially began growing in
significance in the 1970s and 1980s, and every investor knows that the greatest
bull market in US history ran from 1982-2000 (see “Century
of the Dow”). How will the massive inverted derivatives pyramids fare in
brutal and unforgiving bear market environments? Only time will tell.

Our next graph is also from
official OCC data and documents the banks’ total derivatives exposure in
notional terms through the 1990s to Q3 2001.

The red line below is the US
banks’ total notional derivatives exposure on a quarterly basis. The blue line
is the four-quarter moving average of the annual absolute rate of growth in the
total US banks’ derivatives holdings. For example, to get the Q4 2000 data
point the Q4 1999 total notional amount is subtracted from Q4 2000’s, and the
difference is divided by Q4 1999 to determine the absolute year-over-year growth
rate for each quarter. The four-quarter moving average of this quotient is the
blue line shown below, representing the annual growth rate in banks’ derivatives
exposure.

The US banks’ derivatives
holdings literally exploded in the 1990s, up over 721% from Q1 1990 to Q3 2001
to the current unbelievable $51 trillion with a “t”. Before we actually built
this graph, we had assumed that derivatives were growing at an unprecedented
annual rate as the last couple quarters witnessed the explosive 16.8% absolute
growth in six short months. Very surprisingly however, as the blue four-quarter
moving average annual growth line shows above, periods of 20%+ annual
derivatives growth were not uncommon in the 1990s.

The mean level of the blue
line throughout the whole graph is 20.2%, surprisingly high at least to us.
From Q3 2000 to Q3 2001, the latest available data, US banks’ derivatives
holdings grew by an absolute 34.3% (not moving-averaged), which IS high. This
stellar rate of growth is obviously unsustainable! Using some quick
shooting-from-the-hip math and the old “Rule of 72”, a 34% annually compounded
return doubles in a little over every two years. If US banks are to control a
staggering $100t of derivatives by Q4 2003, the graph above will have to shoot
parabolic, looking just like the classic NASDAQ bubble
graph.

One would think that sooner or
later every possible business in the world that could possibly use an
interest-rate swap, currency swap, or any other kind of derivatives contract
would have already deployed them! Clearly current growth rates in US banks’
derivatives exposures will have to abate significantly in the coming years.

Another interesting point to
ponder in the graph above is that the two steepest slopes in the last six years
of the red derivatives line, indicating the fastest growth, occurred during
financial crises. In other words, during episodes of severe market turbulence,
US banks increased their rate of derivatives growth dramatically. Note the
current very steep slope ending in Q3 2001, the quarter of the diabolical
September 11th attacks and subsequent extreme market volatility, and also the
very steep portion in late 1998 near the Russian Debt Crisis which caused
unforeseen volatility that obliterated elite derivatives-laden hedge-fund
Long-Term Capital Management. It appears that whenever sandstorms roar over the
horizon to buffet the inverted derivatives pyramid, that rather than prudently
reducing exposure US banks simply pile and hang more derivatives onto the
windward side of the inverted pyramid to attempt to stay balanced. Not an
encouraging practice!

Interestingly, the current Q3
2001 year-over-year derivatives growth rate of 34.3% is the highest witnessed
since Q4 1998’s 31.6% and Q3 1998’s 30%, all near serious market crises!

As I discussed in Monster, the
vast majority of US banks’ derivatives outstanding are interest-rate
derivatives. This didn’t change in the latest Q3 OCC data. In the Comptroller
of the Currency’s “Table 3”, it claims that of all US banks’ outstanding
derivatives, a staggering 84.1% are interest-rate derivatives. Chase Manhattan
and JP Morgan, the two proud spouses in JPMorganChase, report that 86.2% and
86.9% of their outstanding derivatives contracts are interest-rate derivatives,
respectively. All together, JPM has at least $20,701b of exposure in notional
value terms to interest-rate derivatives contracts (“Table 8”). This is 484
times JPM’s total shareholders’ equity, hyper-extreme interest-rate derivatives
leverage!

As interest-rate swaps and
other interest-rate derivatives contracts are the biggest derivatives game in
town for the mega-banks by far, we decided to look at interest-rate volatility
over the last 20 years or so. Everything else being equal, higher interest-rate
volatilities are the equivalent of the sandstorm-driven wind-loads on our
inverted Great Pyramid of Giza we mentioned above. Extreme interest-rate
volatility should cause great concern for the derivatives departments of the
banks attempting to balance these great inverted pyramids of derivatives.

The blue line in the graph
below is the one-year constant maturity Treasury-Note yield, monthly data direct
from the Federal Reserve. The yellow columns represent volatility in these
interest rates. They are calculated each month as the year-over-year absolute
value of the change in interest rates in percentage terms. (For example, the
December 2000 1-Year T-Note yield less the December 1999 1-Year T-Note yield
divided by the December 1999 yield, absolutely valued.) The resulting quotients
are then smoothed through a 12-month moving average yielding the yellow blobbish-columns
shown below. A change of interest rates from 3% to 4% ((4-3)/3) is considered
33% volatility in this graph, as is a change from 9% to 12% ((12-9)/9), which
also equals 33%.

Interestingly, the current
12-month moving average of absolute interest-rate volatility in the midst of
Greenspan’s frantic interest-rate-slashing extravaganza is currently running
about 44%, the second highest spike in two decades. Not moving-averaged,
December 2001 witnessed annual interest-rate volatility of 66%, extraordinarily
high. The average absolute interest-rate volatility over the last 20 years or
so was only about 17.8%. The last time interest-rate volatility was higher was
during the mid-1990s as the Fed cranked interest rates back up after fighting
the customary early-decade US recession.

In Q4 1995, near the last
great interest-rate volatility spike, there were 558 US banks playing the
derivatives game. Today there are 36% fewer banks left in this rough-and-tumble
and unforgiving arena. Back then there were about $11,095b of interest-rate
derivatives contracts outstanding in notional terms. Today that number has
skyrocketed to $33,496b (“Table 8”), a stunning 202% increase in not very many
years. Can US banks balancing an enormous inverted derivatives pyramid worth
over $33 TRILLION weather this current sandstorm of very high interest-rate
volatility? The answer remains to be seen.

On another derivatives front,
JPM is a defendant in Reginald Howe’s landmark case filed in federal court
alleging active official and money-center bank suppression of the global gold
price. Gold investors will be very interested to know that JPM’s total gold
derivatives exposure in notional terms has plummeted from $57b in Q1 2001, right
after the Howe case was filed (when JPM controlled 68% of all US banks’ gold
derivatives contracts), to $37b in Q3 (“Table 9” in the OCC report, JPM now
controls 55% of all US banks’ outstanding gold derivatives contracts), a
stunning 35% drop in six short months! There are at least a few potential
interpretations that can be advanced here, although there are no guarantees that
any of the following theories is correct.

First, gold derivatives demand
may be shrinking and the market growing less profitable, so JPM chose to begin
making an exit due to normal market conditions. This is the simplest
explanation, but it ignores a lot of critical gold market data and assumes that
there are colossal chance coincidences. The longer I have observed and traded
the markets throughout my life, the less I believe in coincidences. Markets are
giant complex and intricate tapestries of exquisite cause and effect. A small
ripple from a stone tossed into one corner of the great global financial market
pond can quickly spread to and cause chaos in other far-off market areas that
few people would have anticipated.

Second, JPM is well aware of
the mega-bullish fundamentals for gold, including the enormous annual
mined-supply and global demand deficit, the collapsing gold-carry-trade profits,
the vastly overvalued US dollar, and the dangerous and vicious bear markets in
US equities. If JPM expects the gold markets to soon grow much more volatile as
central banks run out of both gold to lend and willing gold borrowers, it would
make perfect sense for JPM to cut its huge gold derivatives exposure and risk
before the coming gold sandstorms strike. Remember, unforeseen volatility is
the bane of derivatives contracts’ existence and can prove lethal, and JPM STILL
has gold derivatives exposure equal to 87% of every dollar of its stockholder’s
equity, extraordinarily high!

Third, JPM could be stunned by
Reginald Howe’s amazingly well-crafted case and can’t believe that Federal Judge
Lindsay hasn’t thrown it out yet. JPM may see a potential discovery phase
hurtling down the pike like a malevolent juggernaut and it wants to exit the
gold market as soon as possible in an attempt to avoid a brewing legal firestorm
and monumental scandal if the gold-manipulation scheme breaks public for
mainstream Americans. Vacating the gold derivatives trade before it has Howe’s
highly-motivated and tenacious Discovery Team pouring over JPM’s private
gold-trading records wouldn’t be a bad idea at all.

There are also other
intriguing theories which exist on the drastic drop in JPM’s gold derivatives
exposure, many of which Bill Murphy has wonderfully articulated in his awesome
and highly-recommended members-only contrarian-investment website
www.LeMetropoleCafe.com.

The vast derivatives mysteries
continue to perpetually fascinate and titillate, defying logic and creating many
more new enigmas that need investigating.

As I wrote back in the
original Monster essay, I am still just as flabbergasted today that big
institutional investors, who have a sacred fiduciary duty to zealously protect
the hard-earned capital entrusted to them by their precious clients, would risk
their clients’ scarce capital by investing in JPM, not just a Dow 30 superbank
but the biggest inverted derivatives pyramid in world history!

A “bank” with $712 of
derivatives exposure for every $1 in stockholders’ capital, in my humble
opinion, is no longer a bank but a de-facto hedge fund.

Now hedge funds are great and
perform a very valuable market service to sophisticated professional speculators
with lots of capital, but a hedge fund is NOT the place to park crucial
retirement investments or college tuition capital! Hedge funds are ultra-risky
speculation vehicles for the elite that specialize in making very large and
risky bets. If JPM is in reality more like a hedge fund than a classic bank,
both retail and institutional investors alike carefully need to reconsider their
JPM exposure. I wrote in the earlier Monster essay…

“In financial circles 10 to 1
leverage is considered very aggressive, 100 to 1 is considered to be in the
kamikaze realm, but we don’t ever recall hearing about large-scale leveraged
operations exceeding 100 to 1 outside of the horrible example of the doomed
super hedge fund Long Term Capital Management. JPM’s management may have
effectively created the most leveraged large hedge fund in the history of the
world by using $42b worth of shareholders’ equity to control derivatives
representing a notional value of a staggering $26,276b.”

Please note that the numbers
in this quote are from the Q1 OCC report, and are far worse now as we noted
above! As I mentioned in Monster, the doomed LTCM had an inverted derivatives
pyramid of an estimated $1,250b supported by only $3b in owners’ capital for an
extreme implied leverage ratio of 417 to 1. JPM’s implied derivatives-to-equity
ratio was sitting at 712 to 1 at the end of Q3 2001, a staggering number beyond
comprehension!

The danger with hyper-extreme
leverage is that even a relatively small unexpected increase in volatility
slamming into the inverted derivatives pyramid on the wrong side, a moderate
sandstorm, can cause crushing losses at the apex of the pyramid, the capital
base of the speculating bank wielding the hyper-leverage. For example, a 1%
fluctuation in a market price is not a big deal on any given day, it happens all
the time. Yet, with even a “mere” 100 to 1 leverage, a 1% price move in the
wrong direction can totally wipe-out the underlying capital. If you have $1k in
capital but control a long bet worth $100k, even a trivial $1k price drop to
$99k obliterates you. Hyper-leverage is playing with fire!

It doesn’t matter how
intelligent the folks are that are managing these gargantuan derivatives
pyramids. They are probably brilliant rocket-scientist types, the best in the
world. Yet Long-Term Capital Management also had brilliant rocket-scientists
running it too, some of the brightest financial minds that ever lived. Even
with that unparalleled brainpower, the mighty LTCM was annihilated by a
relatively small unforeseen market event, the Russian Debt Default, that
completely blew-up its fragile inverted derivatives pyramid portfolio.

In addition, even the most
brilliant market players in the world make mistakes. JPM issued an official
press release on December 19th that claimed it had $2.6b in loans and other
exposure to financial-disaster-du-jour Enron! Initially, JPM had “only”
reported $0.9b of exposure to Enron. $1.7b more is a BIG difference. JPM also
reported that it had at least $0.9b in exposure to Argentina at the end of Q3.
JPM might not lose all the money it is owed by Enron and Argentina, but if it
does that is a staggering $3.5b!

For comparison, realize that
JPM reported that it earned $5.7b last year in its
annual report. If
the Enron and Argentina loans alone were to go bad, that is a potential 61%
haircut in 2001 earnings with only two deals that went sour! The point is not
that JPM did anything wrong in loaning money to Enron and Argentina, just that
even the best of the best cannot foresee some market events which can turn
around and painfully bite them.

The more that I ponder JPM’s
utter dominance of the US banks’ derivatives markets, the more amazed I become
that more professional institutional investors and analysts aren’t at least a
little concerned that the unprecedented Morgan House of Derivatives may be far
overextended. I am also amazed, especially after the exceptionally ugly Enron
implosion, that the OCC and other Federal regulators are apparently not at all
concerned about a single company somehow juggling an exceedingly tangled web of
derivatives worth over $30 trillion in notional value terms. Talk about
systemic risk!

Regardless of how well JPM has balanced its enormous inverted
derivatives pyramid on top of its comparably infinitesimally-small capital base,
in these chaotic markets of today I can’t help but thinking that unforeseen
sandstorms are brewing on the horizons that will place tremendous and unexpected
wind-loads on JPM’s fragile derivatives positions. Hopefully JPM’s inverted
derivatives pyramid will not crumble and fall to the earth, as the consequences
of such an event for the US financial system could be dreadful.